Written by

Dr. Daniel Bachman

Published

June 20, 2014

The mutual fund prospectus tells us that “past performance does not guarantee future returns.” This is an apt description of economic data in early 2014. Although the heavily populated Eastern and Midwestern parts of the United States are now experiencing beautiful spring and summer weather, economic statistics still show the chill of earlier in the year. The most recent GDP number clocked in at essentially no growth. The GDP chill is likely to give way to better news, just as this year’s winter finally gave way to spring.

GDP was held down in the first quarter by a couple of trend reversals in late fall. Inventory accumulation was very high in the last two quarters of 2013. It finally swung back to a more “normal” level, subtracting substantially from economic growth. The jump in net exports in the fourth quarter of 2013 was reversed in the first quarter of 2014. The fall in nonresidential investment, concentrated in equipment, was a bit more worrying. More recent data suggests that this was a fluctuation in the data—perhaps because of weather—rather than a change in the trend.

The details of the GDP release and recent data provide grounds for optimism that GDP is swinging back to growth mode. Consumer spending remains strong. Many observers remarked on the larger-than-normal rise in health care spending. This was very likely the result of previously uninsured individuals using their newly acquired health insurance under the Affordable Care Act. This release of pent-up demand for health care is welcome in an economy that remains below full employment, although the meaning for the long-term stability of the new health care insurance market remains to be seen. Monthly data on durable and nondurable goods purchases shows that consumer spending remains strong in non-health areas as well. The March reading of a 1.4 percent rise in real durable goods spending suggests that the second quarter consumer figure may be quite strong.

Other monthly data is also improving. The most important indicator, the net job gain, was close to 300,000 in April. With unemployment insurance claims moving in a range of around 320,000, and perhaps lower, there is a good chance strong job gains will continue. That is a key to an economy moving up to an underlying rate of growth of 3.0 percent or more.

News on the policy front has also been benign. The Fed has now engaged in four rounds of “tapering.” Despite a decline in the Fed’s take-up of long-term bonds of $40 billion, long-term interest rates have actually fallen. The stability of financial markets is another important key to acceleration in economic growth. Fiscal policy is likely to be more benign in the next year or so as the budget agreement allows for some growth—or at least, no shrinkage—in the government’s demand for goods and services.

European economies are showing some definite signs of growth. The danger of setbacks remains, but the underlying trends still point to continued recovery in Europe. China, on the other hand, is still a source of potential trouble. Many informed observers continue to worry about the country’s shadow banking system. A Chinese crisis, however, is less likely to find weaknesses in the US financial system than a European crisis would have.

The Deloitte economic forecast includes a low-probability scenario in which another financial crisis generates a recession in the United States—but the probability is only 5 percent.

The economy’s underlying growth hasn’t changed much, yet. We’re still moving along at an unsatisfactory growth rate of about 2.0 percent per year. But chances are quite high that we will see stronger growth sometime in the next year and a half.

Scenarios

There are plenty of reasons why actual economic growth might be better or worse than Deloitte’s forecasted baseline. The Deloitte forecast, therefore, includes four different scenarios to illustrate different possible future paths of the US economy that are worth thinking about. Deloitte’s economic forecasting team places subjective probabilities on each of the scenarios.

The baseline (55 percent): We believe the most likely outcome for the economy is a burst of mildly faster growth as risks from abroad and at home fade away. Continued improvement in the labor market and growing demand from abroad convinces business leaders that the economy is really improving. Business investment then joins, adding to demand. As hiring picks up, the labor force participation rate of younger cohorts will begin to rise. As a result, the large amount of slack will prevent rising demand from being translated into inflation. With inflation tame, the Fed is able to continue along the path of gradually reducing its monthly asset purchases (quantitative easing), and by late 2015, begin raising interest rates.

Recession (5 percent): Euro problems flare up, and Europe goes back into recession. One or more countries are forced to exit the euro, raising questions about the valuation of euro assets. These questions then affect several US financial institutions that find themselves long on euro assets at the wrong time. The result is a global financial panic. China’s own financial bubble finally catches up with the country, adding to the panic. Chinese and East Asian growth sputter. Capital flows into the United States to avoid risk in Europe and Asia, and the dollar appreciates. The combination of low foreign demand and financial panic throws the US economy into recession. Timely Fed action offsets the financial crisis after several months, but the impact of low demand, a troubled financial system, and the resulting hit to confidence keep the economy growing slowly. An eventual recovery leads to relatively fast growth several years from now.

Continuing slow growth (20 percent): Weak economic conditions abroad, incomplete fixes to the financial system, and a mismatch between labor needs and the skills of the labor force leave the US economy growing at 2 percent for the next few years. Government spending continues to grow much more slowly than the overall economy, and foreign conditions do not improve. As the long-term unemployed become essentially unemployable, the labor force participation rate remains low, and, wages start to rise. The hoped-for improvement in competitiveness from domestic energy production proves to be less impressive than expected. Incipient signs of inflation cause the Fed to raise interest rates to prevent inflation from getting out of hand.

Coordinated global boom (20 percent): Europe begins to successfully restructure and starts recovering at a fast rate. Emerging markets also pick up momentum as financial problems are resolved in China, and India and Brazil start to adopt more reforms. Capital flows out of the United States and into Europe and the developing world, which causes the dollar to depreciate, further enhancing US exports. Lower energy prices in the United States make the country even more competitive. At home, the resolution of budget issues at both the federal and state levels allows more money to flow into infrastructure investment, creating short-term demand and long-term productivity growth. Growth attracts workers back into the labor market, preventing inflation from picking up and allowing the Fed some room to continue to gradually remove quantitative easing without seeing interest rates rise.

What’s been happening?

The unsurprising succession of spring after winter seems to have brought with it more economic growth. Markets shrugged off the backward-looking GDP number for Q1 at the end of April. They were more focused on the upcoming fine weather and improving data stream. Perhaps it was just spring fever. But the big sources of risk all seemed to be taking an early vacation. For example:

The Fed is now into its fourth round of “tapering.” Financial markets are taking the withdrawal of the Fed from long-term asset markets in stride. Markets expect tapering to end in December, when the Fed will have completely stopped all asset purchases. And yet, long-term assets markets remain stable, and long-term interest rates remain low.

Europe continues to show signs of growth. Although the pickup is slow, and occasional data releases hint at underlying problems, the chances of a Euro-blowup now seem remote.

Budget problems appeared to be behind us until house majority leader Eric Cantor lost his primary election in Virginia. This creates some uncertainty about what might happen in March 2015 when the current suspension of the debt ceiling expires..

The rollout of the Affordable Care Act (ACA) improved substantially. The ACA came into effect in January, and so far, there has been little or no negative macroeconomic impact. Initial implementation of the ACA does not appear to have affected hiring significantly so far. The employer mandate is not in force, so the full impact of the ACA is not yet evident. In any event, the main impact of the ACA in the first quarter was a surge in health care spending. The long-run implications of the ACA on hiring, health care, and the Federal budget remain uncertain, but the short-run impact on the US economy is clearly a small positive.

The US economic debate shifted rather dramatically towards a serious discussion of inequality. This was sparked by the publication in English of a book on the topic by a French scholar, Thomas Piketty.1 The general outline of the problem has been understood for years, but the book seems to have galvanized debate over this issue.

The economy still faces significant risks. And recent positive signs might be just the usual fluctuation of the data, rather than a signal that the economy has begun to accelerate. Europe’s financial imbalances remain of some concern. And China’s lack of transparency makes it hard to be confident in the country’s financial system. While a Chinese financial crisis would probably not affect the global financial system, it could lead to a slowdown in Chinese growth. This, in turn, could have global ramifications.

Sectors

Consumers

Ah, the US consumer—long-time supporter of the global economy, and still surprisingly resilient. Of course, consumers can’t spend money they don’t have, and their incomes are largely dependent on having jobs. As the US economy picks up pace, and as jobs and incomes grow, consumer spending will respond. Just don’t expect US consumers to play Atlas, holding the global economy on their shoulders like they did in the 2000s. The Deloitte forecast expects the US saving rate to remain between 4.5 and 5.0 percent, a good bit higher than in the previous decade.

US households actually face some pretty daunting obstacles in their pursuit of the good life. The biggest of these is growing inequality. The recent publication of Thomas Pikkety’s book on inequality has created a surprising stir for a 600+ page tome on economics replete with charts and data. For a shorter summary of some of the problems raised in the book, see the Deloitte Review article “Mind the gap” by Ira Kalish. The great interest in the topic suggests that US economic policy debates are likely to be more focused on inequality than they were in the past.

Many US consumers spent the 1990s and the 2000s trying to keep up their spending when incomes were stagnant. After all, they kept being assured that technology was transforming the US economy and should be transforming their lives. But now they are wiser (and older, which is another problem as retirements loom without sufficient savings). As long as a large share of the gains from technology and other economic improvements flow to a relatively small number of households, overall US consumer spending is likely to remain relatively restrained.

Consumer news

Real consumer spending accelerated through the first quarter. Health care spending added an unusual 1.1 percentage points to first quarter GDP growth. The pent-up demand for health services by the formerly uninsured lifted demand in that sector. Growth in health services will likely slow back to its longer run pace. Demand for durable goods (particularly cars) has been picking up after falling in December and January.

Employment growth accelerated. The 288,000 jobs gained in April meant that job growth has been above 200,000 for three months running.

Consumer confidence is now at its highest level since the Great Recession started. The personal savings rate has drifted down in the last few months.

Housing

It happens every year. Young people become old enough to leave home and start their own households. But it stopped happening during the recession. The number of households didn’t grow nearly enough to account for all the newly minted young adults. Those young adults would prefer to live on their own and create new households; as the economy recovers, they will do exactly that.

This means the fundamentals are excellent for residential construction. The United States hasn’t been building as many new housing units as the population would normally require for about seven years, since 2008. In fact, housing construction was hit so hard that the oversupply turned into an undersupply, so there’s a big hole that needs to be filled. We’re not returning to 2005, when housing construction powered the economy almost on its own, but this sector will likely be a contributor to growth for a while.

The future of housing may look very different than the past. Growth in new housing construction has been concentrated in multifamily units. And a surprisingly large portion of existing home sales seem to be purchases by investment groups, rather than individuals. Housing credit remains tight, and may be a key culprit in keeping individual purchases of single-family houses low. Young adults also seem to be showing a preference for living in urban rather than suburban communities. These trends suggest that some significant changes from the post-World War II model of single-family home ownership may be on the way.

The forecast now shows sluggish housing construction in 2014, which reflects the soft market at the end of 2013 and beginning of 2014. We expect housing construction activity to begin to grow again this spring, but much of this growth will show in the annual average growth rate from 2014 to 2015.

Housing news

Housing starts stayed below the one million mark for the first three months of the year, then jumped to 1.072 million in April. Much of the growth has been in multi-unit structures, however. Permits—a good indicator of future starts—also jumped in April, entirely because of a rise in multi-family starts.

The 30-year conventional mortgage rate has been holding steady at about 4.5 percent since the beginning of 2014. That’s substantially above the 3.5 percent level prevalent in markets until the middle of 2014, but it is still quite low.

House prices have remained flat this year. While there is no indication that house prices might start falling, level house prices may help to moderate any growth in this sector in the near term. Flat prices and stable interest rates do spell “affordability” in the housing market, especially as employment and wages begin to pick up.

Business investment

There’s a lot of sad talk about the impact of uncertainty on business decisions. In fact, relative to GDP, business investment was one of the better performing sectors in this recovery. With strong profit growth, however, business might have been expected to invest even more. The reasons for this are complex. (See “What’s the Matter with Investment” by Daniel Bachman in Deloitte’s economic data blog “Behind the Numbers.”) Many businesses are still waiting for assurance that they will have customers. Once those customers return, there will be more reason to ramp up investment. Watch what businesses do, not what they say.

Business investment news

Nondefense capital goods shipments—the best high-frequency measure of equipment spending—fell in January, which helped to keep the investment numbers low in the first quarter. There was substantial bounce-back in March.

Interest rates have stabilized, and the stock market is once again on an upward trend. The cost of capital remains quite low. Some businesses (mainly in the tech area) continue to sit on a large pile of cash.

Private nonresidential construction dropped in early 2014, and has not yet recovered. Commercial and health care construction more than accounted for the decline, while manufacturing construction held up much better in the first quarter.

Foreign trade

The United States has long had a voracious appetite for foreign goods, and that’s not going to stop. In the forecast, imports grow at about twice the rate of GDP over the next few years, and they will accelerate along with GDP growth.

However, exports look to prove a pleasant surprise. There are two reasons why US exporters will be happy:

A variety of improvements, ranging from the United States’ lead in technology to cheap natural gas, will help make US manufacturing more competitive with foreign goods.

As risks abroad recede, investors are going to be looking outside the United States for higher returns. That’s not a bad thing for the United States since we, after all, account for a lot of those investors. To get higher returns in places like Europe and Asia, investors will be selling dollar assets—and the value of the dollar will decline. A lower dollar is just fine if it helps improve US competiveness and puts capital where it does the most good globally, so the possibility of a depreciating dollar is to be welcomed.

Foreign trade news

The swing in the contribution of exports was a major factor in the low GDP figure for the first quarter. But exports in March rose 2.1 percent over February. This suggests that exports will contribute to growth in the second quarter.

Imports were up in March, but at about half the rate of exports. Petroleum imports rose in January but have since been falling. The first quarter of 2014 was the first quarter since 2011 that saw petroleum imports rise.

The trade-weighted dollar appreciated slightly over the past six months. The euro-dollar rate has been falling slowly, but the dollar’s value against other key currencies, such as the Canadian dollar, has been strengthening..

Economic news from Europe has been more positive. Industrial production is now growing on a year-ago basis for all four of the major Eurozone countries.

Government

Government spending on goods and services has been stagnant, and the Deloitte forecast doesn’t see much change in the next few years. At the federal level, it is hard to see Congress and the president agreeing on significant new spending over the next five years. The recent budget agreement adds $44 billion to federal spending in 2014. This is a small but welcome increase from the point of view of supporting economic demand. It will directly add about 0.2 percentage points to GDP growth, although some of the spending increase will be offset by the increased fees included in the plan.

The good news for state and local governments is that they likely won’t continue to cut spending. State and local governments are getting some good news from rising house prices and growing employment. Tax collections are up, and that will remove some of the pressure on their budgets.

But those pesky pension liabilities continue to restrain state and local spending. The Congressional Budget Office estimates that there is a shortfall of $2–3 trillion in state and local pension funding. The need to fund these liabilities is likely to keep the lid on state and local spending growth.

Government news

Federal outlays are down $49 billion for the first seven months of the fiscal year. Receipts were up $132 billion. For the first seven months of the fiscal year, the Federal government’s budget deficit is down $181 billion.

Federal government employment continued to fall slowly at a rate of about 7,000 each month for the first four months of 2104. State government employment was essentially flat, while local governments started hiring at a rate of about 15,000 workers per month starting in February.

Labor markets

If the US economy is going to produce more goods and services, it will need more workers. As long as the labor market is out of balance, the currently moderate wage growth will eventually encourage firms to increase capacity by hiring workers. However, employment growth is more likely to occur in industries such as health care and recreation services than in manufacturing. Accelerating production will carry with it an eventual acceleration in employment—and even a mild acceleration in wages.

But a great many people have been out of work for a long time—long enough that their basic work skills may be eroded. When the labor market tightens up, will those people be employable? Once the employment-to-population ratio (rather than the unemployment rate) starts increasing and labor markets begin to tighten, the long-term damage of the 2007–2009 recession will become measurable.

One unusual feature of the current recovery is the decline in the number of government workers. Government jobs were once thought of as recession-proof, but that’s not the case anymore. There isn’t a lot of desire for increased government spending. As a result, government employment is likely to grow slowly at best in the next few years, which may constrain job growth.

Labor market news

Initial claims fell below 300,000 for the first time since the recession.

Payroll employment grew by 288,000 in April. The current trend level appears to be at least 200,000, enough to slowly bring down the unemployment rate.

These assumptions are conservative. Labor force participation rates for older cohorts have actually been trending upwards. If this continues, overall labor force participation rates may be higher than projected here. The assumption that about a third of the drop in the middle age participation rate is permanent is also conservative. The experience of the late 1990s suggests that tight labor markets might yield higher participation rates than this before overall wages begin to rise.

The Deloitte labor force projection sees the participation rate rising about half a percentage point (from 63.2 percent in 2013 to 63.7 percent in 2019) before starting to decline as most of the latent unemployed reenter the labor market and are employed.

Fed staff and officials are quite aware of the potential for the U.S. labor market to supply many more workers than is evident from the unemployment rate. That is why Fed Chair Janet Yellen has been explaining that the unemployment rate is not the only labor force metric of interest to policymakers. If participation rates show signs of rising in response to tighter labor markets, the Fed may put off tightening for longer than some observers expect.

Deloitte labor force projections

This forecast includes an updated projection of the US labor force participation rate. The overall participation rate will be affected by two offsetting trends in the near term. The aging of the population—and in particular, the entrance of early baby boom cohorts into retirement age in the next five years—will push the participation rate down. However, participation rates for younger cohorts have fallen substantially because of the poor labor market. The economic improvement in the Deloitte forecast will almost certainly entice many people in these middle age and, especially, younger cohorts to return to the labor market.

The labor force projection in this forecast assumes the following:
1. Labor force participation rates for over-60s will remain at current levels.
2. Labor force participation rates for under-30s will return to their 1997–2000 average.
3. Labor force participation rates for 30–60-year-olds will return to two-thirds the 1997–2000 average.

Financial markets

Interest rates are among the most difficult economic variables to forecast because movements depend on news. And if we knew it, it wouldn’t be news. The Deloitte interest rate forecast is designed to show a path for interest rates consistent with the forecast for the real economy. But the potential risk for different interest rate movements is higher here than in other parts of our forecast.

The Deloitte forecast sees both long-term and short-term interest rates headed up—maybe not this week, and maybe not this month. The forecast shows the economy regaining its momentum by late 2014, however, and a healthy economy will mean that lending will be once again become costly. The forecast moves interest rates back to “normal” interest rate levels as economic growth accelerates. That’s not a bad thing—unless returning to normal is bad.

Of course, some investors will be caught short. Those are the people who think that interest rates will remain low forever. Some of those will even be so-called sophisticated investors, so plenty of worried headlines will appear when interest rates go up. Don’t be fooled by what is just a welcome return to normal.

But the most sophisticated observers of financial markets know the most important thing about interest rates—they will fluctuate. This is the sector that is most likely to surprise us.

Financial market news

The early excitement about tapering has worn off (a good thing, too). Markets have taken recent anouncements of additional reduction in asset purchases in stride. At the rate of $10 billion per month, the Fed will make its final announcement at either the October or December FOMC meeting (depending on whether the last reduction is $15 billion in October or $10 billion in October and the final $5 billion in December).

Attention will then turn to the timing of the first rise in the Federal funds rate. The Deloitte forecast projects this occurring in late 2015.

10-year Treasury yields fell slightly over the past few months. The stock market continued to do well. Financial conditions remained very accommodative.

Prices

Remember those folks who were convinced that the Fed’s actions in 2009 would create runaway inflation? They might rather you didn’t. Prices have been the most boring part of forecasting for the past five years, and there is no reason to think that’s going to change.

Inflation is hard to come by when the labor market—which accounts for two-thirds of all costs in the US economy—is so slack. Workers don’t have leverage to obtain higher wages when prices go up, and businesses don’t have pricing power to cover higher costs. Instead, shocks from higher energy or food prices have just dissipated into the ether rather than being translated into sustained, higher inflation.

That means that inflation will remain tame at least until the economy reaches full employment. With a labor surplus of 10–12 million people, that will take a while, even in our forecast. So don’t hold your breath waiting for the return of the 1970s. Bell bottoms, disco, and high inflation are all safely in our past (for now).

Price news

The CPI was up 0.3 percent in April, and 2.0 percent over a year earlier. This is above the levels of recent history and recent months, but well within the Fed’s desired range. Core CPI continues to rise at 0.1 percent to 0.2 percent per year.

Final demand PPI was up 2.1 percent, but core final demand PPI (less food and energy) was up 1.8 percent in April. Neither figure indicates a potential acceleration in inflation.

Productivity fell 1.8 percent in the first quarter after growing at 2.0 percent or higher for the previous three quarters. Unit labor costs were therefore up 4.7 percent in the first quarter. This is most likely an artifact of the temporary factors keeping growth slow in the first quarter. It does not create concern (yet) about wage growth pushing up prices.

Appendix: Deloitte economic forecast

Table 1. Deloitte US Forecast: BaselinePercent change, year over year unless otherwise noted.